With ETFs and passive investing continuing to grow in popularity, it is important for investors to understand the various index weighting schemes that our trusted ETFs are tracking.

These differences in weighting schemes can expose investors to different risk and return potential so it is important to always check “under the hood” what type of index an ETF is using as its benchmark.

Let’s take a look at the four main weighting schemes below:

1. Market Value-Weighted – This is the classic weighting style that many of the largest and most popular indices and ETFs are based on. The components of a market value-weighted index are weighted in proportion to each company’s market capitalization (remember that market capitalization = share price x number of shares outstanding) relative to the market capitalization of the whole index. As such, market value-weighted are also commonly referred to as capitalization-weighted indices.

Market value-weighted indices are akin to a weighted average where smaller valued companies represent a less significant portion of the index and larger valued companies represent a greater portion.

The S&P 500 and small-cap Russell 2000 would be popular examples of a market value-weighted index. The logic of the weighted average and its close approximation to changes in investor wealth, has led to the growth in the popularity of market value-weighted indicies ahead of the more old fashion price-weighted indices which will be discussed next.  

Drawbacks: While the rationale for market value-weighted indices is solid with its weighted average calculation, the method has the problem of potentially creating self-fulfilling trends where, because the value of a company is increasing (or decreasing), more passive managers and ETFs are forced to buy (or sell) that company’s share in order to continue to replicate the index.

This creates a momentum tilt within market value-weighted indexes. This can, unfortunately, create counterintuitive situations where overvalued stocks are overweight in the index and undervalued stocks are underweighted. 

Side Note: Index providers often alter their index weightings for “free float” which adjusts the total number of shares outstanding by the amount of company shares not readily available for trading by the public. By adjusting out shares held by company founders or governments, the “free-float” index is more representative of the market value of the companies readily available to be traded.  

• Price-Weighted – This method represents probably the most simple and old fashioned way to compile an index but has significant problems due to its focus on share price. A price-weighted index has its value calculated by simply adding together the share prices of each company in the index and then dividing by the total number of companies in the index. This results in an index value that is the arithmetic average of the share prices in the index. The Dow Jones Industrial Average and Nikkie 225 would be popular examples of price-weighted indices. 

Drawbacks: While simple to calculate, the major drawback with the price-weighted method is that the listed share price of a company does not represent that company’s value as it does not take into account the number of shares outstanding.

For this reason, a smaller market capitalization company could have a larger weighting in a price-weighted index if it has a high share price due to a relatively low amount of shares outstanding.

Likewise, a price change in a company with a high share price will have a larger impact on a price weighted index than the underlying change in market value of the components would suggest.

• Equal-Weighted – This weighting method is exactly as it sounds, with each company in the index receiving the same weight regardless of market capitalization or share price. If there are 20 companies in the index, each would receive a 5% weight. This means that smaller cap companies with the potential for higher growth will have a larger weighting than those in a market value-weighted index.

Equal-weighting also overcomes the issue mentioned previously with the market value-weighted method overweighting overvalued stocks and underweighting undervalued stocks. Furthermore, the equal-weighted method acts with a contrarian tilt by rebalancing the portfolio away from members of the index that have gone up in value and into members of the index that have seen their market values decrease.

Drawbacks: In order to keep the index/ETF at an equal weight there needs to be frequent rebalancing between the companies. This rebalancing comes with added transaction costs that will drive up the expenses of the ETF or any passive investment fund that tracks it.  Also, the exposure to smaller cap companies can add volatility to the index which may not be desired by every investor.

• Fundamental-Weighted – As the passive investment universe continues to grow, fundamental-weighted indices continue to spring up to provide ETFs and passive managers with new benchmarks to follow. The criteria which index inclusion and weighting is based off of, as the name suggests, are “fundamental” analysis metrics such as book value, dividends, revenue growth, etc. Companies with favourable readings for these metrics, per price paid respectively, will carry a larger weight in the index. Some fundamental-weighted indexes will even construct themselves based on multiple fundamental metrics.

The argument for choosing a fundamental-weighted index over the more common and simpler market-value weighted index is that fundamental analysis deserves a place in making proper financial decisions and that it can be done formulaically without a team of active managers.

Similar to the equal-weighted method, there is a contrarian tilt to fundamental-weighted indexes. This contrarian tilt is present because as the fundamental metric gets more expensive in a stock, the index will lower its weighting and, in turn, replace its weight with a peer who is less expensive based on the desired fundamental metric.

Drawback: Fundament-weighted ETFs tend to carry higher expense ratios than their market value-weighted competitors due to higher transactions costs associated with rebalancing as well as the costs associate with data sourcing and analysis required for portfolio construction. Also, it could be argued that attempting to pick and choose which fundamental factors (and the ETFs which track them) will be rewarded in future market conditions strays away from the principles of “passive” investing.

While Fama & French outlined low price-to-book value and small market cap as rewarded factors, there are now multitudes of ETFs tracking fundamental metrics which have no empirical evidence the factors they use in their weighting scheme will be able to achieve returns above the common market value-weighted index… even before considering the higher fees associated with these funds.